2018: is the equities bubble just starting?

Even though the title states that the equities bubble is just starting, we could also be in the last blow-out leg of the equities bubble. However, nobody knows until after a collapse.

Anyway, we can see below that we are in a parabolic push of the risk-on sentiment (SPX/10Y Treasuries ratio). This is similar to the blue parabolic move that occured in November (Tax deal agreement.) This was followed by a pull-back, but the Santa rally pushed markets higher.

We can see that the last day of December had funds pulling money ahead of an expected profit taking sell-off in January. When this sell-off did not materialize on the first trading day, all algos renewed buying with great fury.

We are now I believe at the top of this great buying fury. We should certainly expect some short-term pullback here.

Looking at the 5 years view, we can see that the final two/tree years of the previous administration saw some sort of equilibrium between Equities and Treasuries, while as soon as Trump got elected, equities were in favor.

What happens to equities today is simply a transfer of money from Treasuries as higher rates combined to QE unwind are expected to be very bearish for fixed income instruments. Those who need income hence have to once again turn to the most liquid/stable equities, which are the NQ, the Dow and the S&P500. Small caps are left untouched or even serve as a short hedge. This can be seen in the ETF EV patterns, in the Futures and in the Effective Volume based money flow calculation.

ETFs:

Futures

EV based Money Flow

REITs continue to be bearish as they will be most affected by higher rates.

Note below that the XLRE money flow has been negative for months now. Hence, this is not a new behavior. But it could get worse in terms of Money flow moving from Treasuries to Equities as the QE unwinding process is only starting. Selling fixed assets is only a way to front run the Fed's unwinding process.

This front running process will accentuate the US/Japanese and US/German rates differentials.

We can see below that the US$/Yen exchange rate closely follow the rates differentials.

This is also true for the US$/Euro, except for the past two Months, which show the US$ weakening against the Euro. Something has to give here: either German rates shoot up or the Euro/US$ weakens. Since no inflation is showing in Europe, which still faces uncertainty in Germany and since the Fed's QE unwinding process is far ahead of the ECB's unwinding, it makes sense to expect a weaker Euro.

This is what the Euro TEV pattern tends to tell us.

The US$'s TEV pattern is however still bearsih here.

Conclusions:

What I really want to stress in this Article is the mechanical aspect of the flow of money between instruments types and between countries. 2018 will be the Year of QE unwind. QE has accumulated tons of fixed income papers. This paper is only starting to hit the markets in exchange of US$. However, front running is already showing and we should expect higher US rates on the secondary markets independently of inflation expectation or of the Fed's incremental increases.

I expect that the flow of money going into the large caps will accelerate, but that the small caps will be badly hurt by higher rates. Fixed income will break and then equities will break starting with the small caps. As soon as the large caps drop by 10%-20%, the Fed will reverse QE unwind... and this will also fail, except if QE is restarted with enhanced fury. This will sink the US$ and push commodities/gold/oil prices higher.

While large fund can only buy large caps and short volatility, individualg investors can carry a more balanced portfolio, with the large caps lon positions and small caps short positions.

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